How are mutual funds taxed? Four Ways to Minimize Tax Bills

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Taxes can be complicated and can be extremely complicated for investors. If you own mutual fund shares, you may be subject to taxes on dividends and revenues. The decision will be made by the fund manager on behalf of all shareholders, so there is no even a statement about when the fund’s holdings will be realized.

But breaking things down into different types of taxes is actually pretty easy. Here are the main mutual fund taxes to watch out for, and some strategies to minimize those taxes.

When do I pay taxes on mutual funds?

Investors can be a great option for investors as they can hold a diverse portfolio of securities due to their relatively small investments. However, investing in mutual funds means that you cannot control individual holdings of the funds selected by the fund manager. The price of the fund, or net asset value (NAV), increases based on the performance of the fund’s underlying holdings.

Taxes on mutual funds when selling stocks

If securities held in a mutual fund work well, the fund’s NAV will be highly valued and profitable from the original purchase. You will need to pay taxes on this profit, but understanding exactly how much you owe can be complicated.

• If you purchase all the stocks at once, the calculations will be relatively simple. If you subtract the price per share from the price sold, the difference equals profit per share.
• However, most people consistently buy mutual funds over time. This means you have paid several different prices for your stock. You can calculate gain using the average cost of all your stocks you own, or use a specific stock on a specific cost basis.
• The amount of time you hold your stock is also important. If you own shares for more than a year, your profits are considered long-term, so you can take a break at the capital gains tax rate. For profits from stocks that are less than a year, you pay taxes at the usual income rate.

Taxes on mutual funds you own

Even if you still own the fund, taxes on mutual fund stocks can be triggered in two ways.

• Dividends and Interest: If the Fund holds securities that pay dividends or interest, the Fund may distribute the shares of those payments to the customer and borrow taxes on the proceeds. Some mutual funds, such as municipal bond funds, focus on investments that are exempt from federal income tax. If you receive dividends or interest from the fund you hold, you will likely receive an IRS tax form (1099-DIV) indicating your income from this year’s fund. This form may come from the fund company itself or from the online broker.
• Capital Gains: Fund managers can sell fund securities for funds and cause capital gains taxes. The impact of taxes depends on the amount of time the fund holds the shares it has been sold. Capital gains are usually distributed once a year to shareholders of the fund and are owed taxes on profits.

For more information on taxation of investment income, see IRS Publication 550.

How to minimize mutual fund taxes

Not everything is bad because taxes on mutual funds are indications that they have received or recognized the profits in some form. However, avoiding taxes can help you achieve higher long-term returns. Below are four best ways to minimize taxes on mutual fund investments:

1. Holds shares in your tax account: One of the easiest ways to avoid taxes on mutual fund investments is to hold shares in tax accounts such as 401(k) and traditional IRAs or Roth IRAs. Your investments are allowed to grow tax-free. This means you will not pay taxes on the distributions you receive or the profits you realize. In the case of a Roth IRA, you will not pay taxes on your withdrawal.
2. Holding funds over the long term: Holding your funds for more than a year will allow you to pay your taxes at a long-term capital gains rate, a major benefit for most investors.
3. Avoid certain types of funds: If you want to avoid taxes, you probably want to avoid dividends or funds that focus on high portfolio turnover. Index funds are usually the best option as they pay moderate dividends and have low turnover rates.
4. Tax LOSS Harvest: To use weight loss harvesting strategies, you can sell some investments to offset your profits and reduce your tax payments.

You can also limit tax exposure by holding funds (ETFs) traded on exchanges rather than mutual funds. ETFs often make similar investments to mutual fund counterparts, but are tax-efficient, not necessary to distribute realized capital gains.

Mutual Fund Tax FAQ

Conclusion

Taxes on mutual funds can be complicated as dividends and fund profits can be taxed even before the stock is sold. Of course, when you decide to sell, the profits of the fund’s value will also be taxed. The easiest way to avoid this is to own a mutual fund in a tax retirement account, such as IRAS or 401(k)s. You can also keep your investments in the long term. By doing so, if you owe taxes, you can pay at a lower long-term capital gains rate.

Editorial Disclaimer: All investors are advised to conduct their own independent research into investment strategies before making an investment decision. Furthermore, investors recommend that past investment products performance is not a guarantee of future price increases.